The 'Widow's Curse Myth' or Reality?

Ominous storm clouds darkened in the U.S. this week, as a faltering equity
market and weakening dollar joined a troubled Credit market. Globally, there
was nothing but distressing news from beleaguered Argentina and Japan. For
the week, the Dow dropped 2% and the S&P500 declined 3%. The Transports
and Utilities declined 2%, while the Morgan Stanley Cyclical index sank almost
4%. The Morgan Stanley Consumer index dipped just 1%. Selling was broad-based,
with the small cap Russell-2000 and S&P400 Mid-Cap indices declining 2%.
The technology rally reversed abruptly, with the NASDAQ100, Morgan Stanley
High Tech, and Semiconductor indices dropping 4%. The Street.com Internet index
sank 7% and the NASDAQ Telecommunications index dropped 6%. The Biotechs were
also hit hard, sinking 6% for the week. Considering underlying fundamentals,
it is not surprising that financial stocks also came under selling pressure.
For the week, the S&P Bank index declined 3% and the AMEX Securities broker/dealer
index dropped 4%. With bullion up almost $4, the HUI Gold index added 2%.

Hopes that the Credit market had navigated through the storm were dashed over
the past two sessions, with implied yields on agency futures jumping 28 basis
points to the highest level in about 5 months. Implied agency yields have now
surged more than 110 basis points off of early November lows. For the week,
2-year Treasury yields mustered a 3 basis point decline to 3.15%, with 5-year
yields edging one basis point higher to 4.89%. The key 10-year Treasury yield
added 18 basis points in the past two sessions to 5.19%, up 3 basis points
for the week. Long-bond yields declined 1 basis point to 5.58%. Benchmark Fannie
Mae mortgage-back yields rose 2 basis points to the highest level since early
August. Considering the record mortgage originations over the past four months,
there is an enormous amount of mortgage paper now under water, some considerably.
In a potentially problematic development, implied yields on agency futures
jumped 10 basis points this week. The spread on the benchmark Fannie Mae 5
3/8% 2011 note widened 2 to 74. The benchmark 10-year dollar swap spread widened
8 to almost 80, its widest level since mid-September. With the dollar dropping
1% this week, we did see the first hints in some time of the systemically problematic
confluence of rising rates, widening spreads, and a faltering greenback.

Standard & Poor's Dec. 12, 2001"Credit card charge-off rates
increased in October 2001, according to Standard & Poor's Credit Card Quality
Indexes. These indexes monitor the performance of approximately $373 billion
in receivables held in trusts of rated credit card-backed securities, which
make up nearly two-thirds of the total bankcard market. Issuers distributed
October performance data on Nov. 15, 2001. The monthly charge-off rate rose
30 basis points (bps), to 6.8% in October from 6.5% in September. The increase
represents a 135 bps increase in charge-off levels compared with a year ago Delinquencies
averaged 5.3% in October, a 20 bps increase from September and a 70 bps increase
from a year ago. Seventy-five percent of the trusts tracked by the indexes
reported an increase in 30-plus day delinquencies this month, and almost 80%
of the trusts reported an uptick in delinquencies in the 90-plus days bucket Subprime
lenders who have witnessed the most rapid growth over the past few years, and
have yet to manage through a recession, will feel the increase in losses more
directly. These same lenders suffered the greatest absolute increase in losses
this month. The average increase in losses in October for prime issuers was
relatively modest, less than 40 bps. The subprime section, however, averaged
an increase in defaults of 165 bps."

Standard & Poor's Dec. 11, 2001"Standard & Poor's today
placed its single-'B'-minus ratings on various series issued by Home Improvement
Loan Trust, Home Equity Loan Trust, Home Improvement & Home Equity Loan
Trust, Green Tree Financial Corp., Green Tree Recreational, Equipment & Consumer
Trust, and Manufactured Housing Senior/Sub Pass Thru Trust, Green Tree Financial
Corp., and Conseco Finance Corp. on CreditWatch with negative implications
(see list). Each of the certificates has credit support from a limited guarantee
provided by Conseco Finance Corp. and from monthly excess spread. Without the
use of the limited guarantee, the monthly excess spread may be insufficient
to protect against losses over the life of the transactions. The ratings for
the affected classes are dependent upon Conseco Finance Corp.'s ability to
provide payments under the limited guarantee."

U.S. Credit quality continues to deteriorate by the week, with Moody's today
cutting both Calpine and K-mart debt to junk status. Ratings agencies also
downgraded a whole host of Enron-related transactions. From Moody's: "Enron
Corp.'s bankruptcy has resulted in the downgrade of lower-rated notes within
18 structured bond transactions " From Dow Jones' Christine Richard: "Providian
Financial, which was reined in by U.S. banking regulators last month after
it announced mounting credit losses, faces a tightening liquidity situation While
regulators haven't restricted Providian's ability to raise funds via certificates
of deposit, a number of CD brokers have ceased to market the securities. A
spokesman for Providian confirmed that Merrill Lynch, Paine Webber and Morgan
Stanley Dean Witter no longer quote rates for Providian CDs."

Fannie Mae's November numbers are out. Business volume (mortgage purchases)
was a record $61 billion ($732 billion annualized!) and up 30% from October,
with an average yield for retained mortgages at 5.96%. Retained commitments
surged to $49 billion, also a record. Year-to-date, Fannie's total book of
business is up $224 billion (18% annualized) to $1.539 trillion, with Fannie's
outstanding mortgage-backs having increased $136 billion (21%) and it retained
portfolio having expanded $89 billion (16%) to $696 billion. Interestingly,
Fannie's retained portfolio increased at only a 5% rate during November, a
trend worth following closely. The company's delinquency rate increased one
basis point to 0.46%. It is worth noting that total outstanding mortgage-back
securities expanded at an 18% rate during the past two quarters, compared to
8.7% growth last year. Who is buying this mortgage related paper? During the
past three quarters, Credit market instruments held by the securities broker/dealers
increased $146.3 billion to $369.9 billion (87% annualized).

Dow Jones Dec. 10, 2001 - "A rush by state and local governments to sell
debt issues is making 2001 one of the biggest years ever for sales of new municipal
bonds. The borrowing binge, which isn't expected to end soon, was spurred in
part by lower interest rates. But even if rates rise, governments will continue
borrowing more to help close budget gaps stemming from the impact of a sluggish
U.S. economy on state and local revenue, analysts believe Through the
first 11 months of 2001, munibond sales totaled $251 billion, up 40% from the
same period in 2000, according to Thomson Financial Securities Data. Sales
for the entire year could total $270 billion, the third largest volume on record,
analysts say."

Year-to-date, 197 convertible bond deals have been sold for total issuance
of $99.4 billion. This compares to 146 deals priced last year raising $61.6
billion, and 112 deals raising $41.3 billion during 1999. Almost $21 billion
of converts were issued during October and November, up 66% from last year.
Looking at the motley crew of billon dollar plus borrowers, we see Agilent
Technologies, Xerox, Cendant, Motorola, Nortel, Sprint PCS, Lucent, Household
International, Echostar, Nextel, NTL, Verizon, Calpine, Tyco and, last but
not least, Enron. The leveraged speculating community is providing the majority
of the demand fueling this boom.

About $5 billion of asset-backed securities were sold this week, increasing
year-to-date issuance to $268 billion (up 17% from total record year-2000 issuance).
From Wachovia Securities' CDO Weekly: "For the second consecutive week,
primary issuance in the high-yield market topped the $2 billion mark with the
strong possibility for this week's total to again reach $2 billion in proceeds.
The current pace of weekly volume has not been seen since last summer. Last
week, 10 transactions were priced totaling $2.4 billion in proceeds. It was
again an issuer's market as four issuers were able to price their transactions
at the low end of price talk and three were able to upsize transactions or,
in a few cases, do both The market continues to be characterized as cash
heavy. Last week AMG reported inflows of $280 million, marking the eighth consecutive
week of positive fund flows "

Between the continued explosion of mortgage credit, and the record issuance
of converts and CDO (collateralized debt obligations) instruments, one cannot
be the least bit sanguine about the either the quantity or quality of debt
issuance. As we have stated before: the intractable problem with the U.S. Credit
Bubble is that it by necessity creates too much debt of increasingly poor quality.
It is also obvious that the Enron implosion is one more serious blow to this
fragile Wall Street "structured finance" edifice. And while the Pavlovian
market response has been to rejoice in the heightened liquidity assured by
yet another round of financial crisis, after years of incessant overliquefication
we have reached the point that the true effects are minimal, fleeting and in
the end self-defeating.

And perhaps a weak economy negates the relevance of uncontrolled money market
deposit expansion, runaway money supply growth, extreme excesses throughout
mortgage finance, unprecedented financial sector speculation and leveraging,
and continued booming issuance of suspect Wall Street financial claims, but
we just don't think so. Our analysis leads us to fear that the serious structural
U.S. financial and economic maladies have yet to surface, and a much more problematic
systemic crisis will quite likely commence with the tempering of recent heated
but unsustainable money and Credit expansion. Bond market action signals that
this is now in the offing, while a shaky dollar would provide confirmation.
With this in mind, I will again (my apologies!) plug away at some "old
fashioned" monetary analysis, if for no other reason than it is being
almost completely ignored by conventional economists with their focus on CPI
and GDP. There is, as well, the now long-standing fixation on traditional bank
Credit - and the erroneous (dangerous) notion that only banks create money
and Credit - to the exclusion of other financial intermediaries that have been
the leading instigators of monetary excess throughout this most unusual cycle.
I can only assume that this is the explanation for what has been for some time
incredible blindness to glaring financial abuses, although I do draw motivation
from the belief that unsound economic theory has been a contributing factor.
Not only is this environment extraordinary for allowing money and Credit expansion
to run completely unchecked, there isn't even discussion as to whether this
is a good idea, or hardly a peep that history tell us rather clearly that this
is a disaster in the making.

One must again go back decades to locate deep analysis and colorful discussion
of the key economic issues of our time - the nature of money, the ramifications
for severe monetary excess, and the powerful role played by finance and financial
intermediaries. I apologize (again) that the nature of the material is tough
sledding. I do, however, believe there is significant pertinent insight to
be garnered from slogging through the analysis.

John G. Gurley and Edward S. Shaw (G&S) fired an initial major salvo with
their 1955 article in the The American Economic Review (AER): "Financial
Aspects of Economic Development":

"Economic development is commonly discussed in terms of wealth, the
labor force, output, and income. These real or 'goods' aspects of development
have been the center of attention in economic literature to the comparative
neglect of financial aspects. Yet development is associated with debt
issue at some points in the economic system and corresponding accretions
of financial assets elsewhere. It is accompanied, too, by the 'institutionalization
of saving and investment' that diversifies channels for the flow of loanable
funds and multiplies varieties of financial claims. Development also
implies, as cause or effect, change in market prices of financial claims
and in other terms of trading in loanable funds. Development involves
finance as well as goods."

Importantly, the "radicals" G&S focused directly on the role
of financial intermediaries in "transmitting loanable funds between
spending units," and the "inadvertent undervaluation by
economists of the role that finance plays in determining the pace and pattern
of economic growth "

"A complete set of social accounts would report the flows of loanable
funds between spending units and the corresponding changes in financial
statusWe are deviating from conventional doctrine in regarding
the banking system as one among many financial intermediariesWe
take exception to the view that banks stand apart in their ability to create
loanable funds out of hand, while other intermediaries in contrast are
busy with the modest brokerage function of transmitting loanable funds
that are somehow generated elsewhere."

"Both banks and other intermediaries have the capacity to create
special forms of financial assets that surplus units may accumulate
as the reward for restraint on current or capital spending. Banks alone
have the capacity to create demand deposits and currency, to be sure, but
only savings and loans associations can create savings and loan shares: both
'create credit,' both transmit loanable funds, both enable spending units
to diversify their portfolios."

"Banks do have a virtual monopoly of the payments mechanism,
and only claims upon monetary intermediaries embody the privilege to use
this mechanism. The fact that other intermediaries make use of the payments
mechanism, which the banks administer, has sometimes been interpreted to
mean that other intermediaries have the inferior role of brokerage in loanable
fundsBoth types of institutions, on the contrary, are loanable-fund
brokers. Both create credit. Whether it is the banks or others which create
credit in any period depends not on the banks' role in administering
the payments machinery but instead on the preference of spending units
for deposits and currency to hold against other financial assets to hold."

"If these other assets are substitutes for the given stock on money
in the portfolios of spending units, a demand for them brings nonbank intermediaries
to the bond market to compete for bonds with spending units. Then the
price of bonds must be higher and the interest rate lower than when banks
are the sole intermediaries.

"An additional complexity is that development of financial institutions,
including nonbank intermediaries, is both a determined and a determining
variable in the growth process."

In an interesting rebuttal - "Intermediaries and Monetary Theory: A Criticism
of The Gurley-Shaw Theory", (AER, 1958) - J.M. Culbertson takes issues
with G&S's unconventional analysis, but does state, "if these ideas
are valid, they call for wholesale revision of our thinking about monetary
theory and economic stabilization."

Culbertson recognized the main issue: "Are Commercial Banks Unique
in Their Ability to Create Credit?

(G&S) explicitly propose a departure from the usual way of looking
at banks in the economy This difference of view, whatever we
may decide is its exact nature, would seem to have policy implications.
If commercial banks are not unique, then why should we apply to them a
special apparatus of control? If they are unique in some relevant
sense, this cast doubt on the appropriateness of the (G&S) suggestion
that control should aim at all financial intermediaries and should
aim at controlling the total volume of obligationsrather than
being limited to bank credit and the money supply. The generally
accepted doctrine seems to be that commercial banks are unique because
of two related facts: (1) Commercial banks are the only private institution
whose debt serves as a generally acceptable medium of exchange,
as money. Money is a unique asset (2) Because it creates
money, the banking system can affect the volume of its liabilities and
can create or extinguish credit, or loan funds, in a way that no other
financial institution canThe usual view is that intermediaries
cannot themselves create credit or loan funds, but rather play a middleman
role in conveying to their ultimate users loan funds brought into being
by others. Intermediaries perform a function parallel to that of the
merchant in other lines; they transmute the debt created by borrowers into
something more attractive to lenders." (p. 120)

Culbertson, supporting conventional doctrine that not only won the day but
survives to this day, states that "variations as occur in the rate of growth
of outstanding obligations of intermediaries arise mainly out of changes in
economic and financial conditions that affect the extent to which customers
desire to take advantage of the standing offer of the intermediaries, rather
than out of any particular decisions or actions on the part of the intermediaries
themselvesDiscipline over financial intermediaries is exercised
in an immediate and direct manner by their creditors. Until someone brings
money into a savings and loan association to exchange for its obligation, the
association cannot lend money " On the other hand, "the banking
system 'creates credit' by acquiring debt and creating demand deposits to pay
for it. The commercial banks do not need 'to borrow loanable funds from
spending units with surpluses' in order to extend credit " (p.
120)

From Culbertson's conclusion: "The theoretical innovations upon which
(G&S) have built their argument are radical. If we accept them, we should
undertake a drastic reconstruction of banking theory, debt management theory,
financial analysis, and the theory of economic stabilization On the
other hand, if the authors cannot convince us of the validity of their theoretical
innovations, their main argument and conclusions are untenable. Then, the banking
system has not "regressed" The question is whether the (G&S)
theoretical framework is a valid basis for the inquiry, and is an improvement
over our accustomed tools of analysis. It seems to me that, on the contrary,
it represents a step backwards."

A snippet from G&S's reply: "Our main interests are in analyzing
the relationship between real growth and financial growth, in isolating
the function of intermediation for special study, and in considering
the relative roles during the growth process of monetary and nonmonetary
intermediaries... we are interested in relative supplies of direct
and (monetary and nonmonetary) indirect debt and in the public's choice
between these financial assets." (p. 132/133).

G&S further expanded key aspects of their unconventional analysis in a
paper "Financial Intermediaries and the Saving-Investment Process" published
in the March 1956 Journal of Finance:

" It has seemed to be a distinctive, even magic, characteristic
of the monetary system that it can create money, erecting a 'multiple expansion'
of debt in the form of deposits and currency on a limited base of reserves. Other
financial institutions, conventional doctrine tells us, are denied this creative
or multiplicative faculty. They are merely middlemen or brokers, not manufacturers
of credit. Our own view is different each kind of non-monetary intermediary
can borrow, go into debt, issue its own characteristic obligations - in short,
it can create credit Moreover, the non-monetary intermediaries are
less inhibited in their own style of credit creation than are the banks in
creating money. Credit creation by non-monetary intermediaries is restricted
by various qualitative rules. Aside from these, the main factor that limits
credit creation is the profit calculusThe 'multiple of expansion'
is a remarkable phenomenon not because of its inflationary implications,
but because it means that bank expansion is anchored, as other financial
expansion is not, to a regulated base. If credit creation by banks is miraculous,
creation of credit by other financial institutions is still more a cause
for exclamation." (p. 422)

This is wonderful, strikingly pertinent analysis. Yale's James Tobin was also
a prominent player in the "money" and financial intermediaries debate,
publishing a series of articles including his classic "Commercial Banks
as Creators of 'Money'" in 1963. His article compared the traditional "Old
View" with the "New View" championed by Gurley and Shaw:

"A more recent development in monetary economics tends to blur the
sharp traditional distinctions between money and other assets and between
commercial banks and other financial intermediaries; to focus on demands
for and supplies of the whole spectrum of assets rather than on the quantity
and velocity of 'money'; and to regard the structure of interest rates, asset
yields, and credit availabilities rather than the quantity of money as the
linkage between monetary and financial institutions and policies on the one
hand and the real economy on the other. (p. 410)

Tobin's work also addressed "The Widow's Curse Myth", concluding "commercial
banks do not possess, either individually or collectively, a Widow's Curse which
guarantees that any expansion of assets will generate a corresponding expansion
of deposit liabilities. Certainly this happy state of affairs would not
exist in an unregulated competitive financial world." "Quite apart
from legal reserve requirements, commercial banks are limited in scale by the
same kinds of economic processes that determine the aggregate size of other
intermediaries there is at any moment a natural economic limit to the
scale of the commercial banking industry. Given the wealth and the asset
preferences of the community, the demand for bank deposits can increase
only if the yields of other assets fall." Central to Tobin's analysis
is his view that "the scale of bank deposits and assets is affected by
depositor preferences and by the lending and investing opportunities available
to banks." "Without reserve requirements, expansion of credit
and deposits by the commercial banking system would be limited by the availability
of assets at yields sufficient to compensate banks for the cost of attracting
and holding the corresponding deposits The expansion process lowers
interest rates generally but ordinarily not enough to wipe out the banks'
margin between the value and cost of additional deposits. It is the existence
of this margin - not the monetary nature of bank liabilities - which makes
it possible for the economics teacher to say that additional loans permitted
by new reserves will generate their own deposits."

That same year Tobin and his Yale associate William C. Brainard co-authored
an article, "Financial Intermediaries and the Effectiveness of Monetary
Controls" (AER, May 1963), posing the important and still unresolved question: Does
the existence of uncontrolled financial intermediaries vitiate monetary control?
What would be the consequences of subjecting these intermediaries to reserve
requirements or to interest rate ceilings? The paper admittedly addressed
these key issues "theoretically and at a high level of abstraction." "The
main conclusion can be briefly stated. The presence of banks, even if they
were uncontrolled, does not mean that monetary control through the supply of
currency has no effect on the economy. Nor does the presence of nonbank intermediaries
mean that monetary control through commercial banks is an empty gesture."

Much more interesting, however, were the accompanying AER discussion papers.
From noted economist and leading inflation authority Abba P. Lerner:

"It seems to me that a reaction to the historical neglect of nonbank
financial intermediaries takes the form of an overemphasis on the similarities
between them and commercial banks. The famous proposition that banks differ
from other financial institutions in that they can 'create money' and that
this is why they have to be regulated while the others need not, is turned
around because of this. The (Tobin & Brainard) statement made
that 'it is more accurate to attribute the special place of banks among intermediaries
to the quantitative restrictions to which banks alone are subjected than
to attribute the quantitative restrictions to the special character of bank
liabilities,' amounts to saying that banks are not regulated because they
create money; they create money because they are regulated.

It is precisely the special quality of banks, or rather of the banking
system, that in such an expansion it is quite peculiarly favored by being
able largely to count on retaining possession of what is sells and thus
to have it available for still further expansion. The explanation of this
peculiar power lies, of course, in the banking system's covering such a
large part of the financial transactions of the economy that, unlike a
relatively small nonbank financial intermediary, it can count on its loans
coming back to it somewhere as a deposit. But this 'Widow's Curse' aspect
of the banking system is central to the issue. This is the early macroeconomics
of the banking theory of money or credit creation that used to be so vehemently
denied by outraged microbankers. And without the restrictions, the credit
creation or money creation by the banking system would have been much greater
than could have been absorbed without severe inflation. That is why
even Milton Friedman recognizes the desirability of social control over
the creation of money, and why it seems to me more appropriate to say
that reserve requirements and other restrictions are imposed on the banking
system because it would otherwise have created too much money. The restrictions
are responsible for the power of the banking system to create money only
in the sense that by preventing the actual creation of money it keeps the
potential, the power, of creating money from being used up."

In the greatest (unrecognized) modern irony of monetary theory, I propose
that the infamous (but long forgotten) Widow's Curse is anything but a Myth.
Moreover, and what makes this so fascinatingly ironic, this phenomenon has
been completely missed because of contemporary doctrine's faith that "only
banks create money." Nonbanks specifically are not merely "middlemen" as
held by conventional thinking and, in reality, have come to possess monetary
capabilities of an incredibly powerful nature denied by theorists for decades
to exist for even the banking system. In fact, it has not been the expansion
of bank deposits that has created an inexhaustible pool ("Widow's Curse")
of loanable funds as much as it is the creation of financial sector deposits,
especially money market fund intermediation. It is valuable for us to again
carefully ponder the previous paragraph from Abba Lerner, and I will attempt
to integrate my oft-used example of Fannie Mae borrowing money market fund
deposits to finance the purchase of mortgages.

"It is precisely the special quality of the banking system, that
in expansion it is quite peculiarly favored by being able largely to count
on retaining possession of what is sells and thus to have it available for
still further expansion."

When Fannie Mae borrows from a money market fund - exchanging a short-term
electronic "IOU" for "loanable funds" - and uses this liquidity
to acquire mortgages (say from a hedge fund or Wall Street firm), these "loanable
funds" (proceeds from the sale to Fannie Mae) are then immediately deposited.
This allows the money market fund complex to "retain possession of
what it sells" - "loanable funds" - and to have
it available to Fannie Mae (or other money market borrowers) for still
further expansion.

"The explanation of this peculiar power lies, of course, in the banking
system's covering such a large part of the financial transactions of the economy
that, unlike a relatively small nonbank financial intermediary, it can count
on its loans coming back to it somewhere as a deposit."

The explanation of this peculiar power lies in the money market system's covering
such a large part of financial transactions in the securities markets that
it can count on its loans for the purchase of securities coming back
to it somewhere as a money market fund deposit. It may be helpful to
think of the evolution of the money market fund complex as a parallel unregulated "banking" system that
has developed concomitant with the expansion of non-bank intermediaries (especially
the GSEs, securities firms, Wall Street "structured finance," hedge
funds, etc.), with the keen/precarious "advantage" of operating without
reserve or capital requirements. While it garners shockingly little attention
considering the ramifications, the money market fund complex has attained a virtual
monopoly on the payment mechanism for the explosion of securities transactions.
One must also appreciate that the vast majority of money fund assets (loans)
are liabilities of institutions aggressively leveraging holdings of financial
assets - the government-sponsored enterprises, "repurchase agreements" financing
securities holdings, short-term loans to securities dealers and various asset-backed/"structured" vehicles.
This credit mechanism is quite peculiar as it largely isolates "loanable
funds" creation - and deposit expansion - within the securities marketplace.
After all, if one borrows in the money market to fund the purchase of securities,
the seller will today almost certainly immediately deposit proceeds directly
into the money fund complex, where it is immediately available to fund additional
loan expansion.

"But this 'Widow's Curse' aspect of the banking system is central to
the issue."

This "Widow's Curse" - "which guarantees that any expansion
of assets will generate a corresponding expansion of deposit liabilities" -
aspect of the U.S. financial system is today paramount to the issue of financial
fragility. It is the "Widow's Curse" that has been the key source
of finance for an historic financial pyramid. The paradox is that runaway
Credit excess directed at the securities markets - with the consequent explosion
of broad money supply - can coincide seductively with relatively stable consumer
prices. As discussed in recent Bulletins, the analytical focus must be to
identify the key "transmission mechanisms" - the "flows of
loanable funds" - created through dominant monetary processes. And with
the massive Credit inflation prevalent in the U.S. "financial sphere," this
has actually only instilled a dangerous complacency in regard to general
monetary stability. Amazingly, the Fed to this day continues to aggressively
accommodate the most dangerous and unprecedented inflation of financial claims
- The Widow's Curse of financial Credit.

And from Tobin: " The scale of bank deposits and assets is affected
by depositor preferences and by the lending and investing opportunities available
to banks." Tobin's view of the "Widow's Curse Myth" rests squarely
on his analysis that there is a "natural economic limit" to the quantity
of banks assets (loans) that, especially created in large amounts, would provide
a yield greater than those required by depositors enjoying such strong demand
for their "savings." I have no problem with this as it relates to
lending to finance real economic investment. But that's certainly not the prominent
dynamic of The Great Credit Bubble. Importantly, Tobin's analysis breaks down
completely when the key point of monetary injection - the "flow of loanable
funds" - is in the securities markets. As we have witnessed, there is no
natural limit to the amount of Credit financing the acquisition of assets.
In the case of real estate assets, lending excess feeds inflation and only
self-reinforcing demand for additional Credit. Even more potent "Widow's
Curse" dynamics are prevalent in lending in financial asset markets, where
both prices and the stock of securities can be inflated very rapidly, as we
have experienced.

From Tobin: "It is the existence of this (lending) margin - not
the monetary nature of bank liabilities - which makes it possible for the
economics teacher to say that additional loans permitted by new reserve
will generate their own deposits."

I would argue that today we operate in an environment with basically unlimited "margin," as
uncontrolled money market borrowings at exceedingly low interest rates are
used to finance holdings of higher-yielding securities (such as agency notes,
mortgage-backs, Credit card receivables, CDO instruments, converts, and corporate
bonds). And it is this self-reinforcing explosion of mortgage and asset-backed
lending creating the fodder for ever-larger amounts of "spread trades" and
other leveraged speculations. Unconstrained by reserve or capital requirements,
and thus far with unlimited "margin," the money fund complex (and
its GSE and security dealer partners) operate absolutely with a mechanism that guarantees
that any expansion of assets will generate a corresponding expansion of deposit
liabilities. The Widow's Curse is today no myth, but instead an extraordinarily
precarious reality.

And back to Culbertson's rebuttal to Gurley and Shaw:

"Variations as occur in the rate of growth of outstanding obligations
of intermediaries arise mainly out of changes in economic and financial
conditions that affect the extent to which customers desire to take
advantage of the standing offer of the intermediaries, rather than out
of any particular decisions or actions on the part of the intermediaries
themselvesDiscipline over financial intermediaries is exercised
in an immediate and direct manner by their creditors.

This analysis also is today categorically inaccurate. The growth of outstanding
obligations of intermediaries arises specifically from their aggressive lending
activities. Moreover, there is little or no discipline over financial intermediaries
exercised directly by their creditors. There is today insatiable demand for
money market fund liabilities, as these deposits are perceived to be safe and
liquid "money."

And this returns us "full circle" to Gurley and Shaw:

Credit creation by non-monetary intermediaries is restricted by various
qualitative rules. Aside from these, the main factor that limits credit
creation is the profit calculus

With implied government guarantees backing the explosion of GSE debt combined
with the financial alchemy of contemporary Wall Street "structured finance," the
U.S. financial system has enjoyed the capacity of transforming unlimited quantities
of risky loans into top-rated liabilities ("money") intermediated
through the money market fund mechanism. These processes have completely mitigated
what would have traditionally served as restraining "various qualitative
rules" and other market forces. And with the Fed "pegging" short-term
rates, assuring endless liquidity, and reducing rates aggressively at the first
sign of system stress, Credit creation has not yet been in the least bit limited
by "profit calculus" or any calculus, for that matter.

And to try to wrap up this difficult analysis, a prescient paragraph from
John G. Gurley and Edward S. Shaw: "Financial Aspects of Economic Development," (AER,
1955):

"The lag of regulatory techniques behind the institutional development
of intermediaries can be overcome when it is appreciated that 'financial
control' should supplant 'monetary control.' Monetary control limits
the supply of one financial asset, money. With a sophisticated financial
structure providing financial assetscontrol over money alone
is a decreasingly efficient means of regulating flows of loanable funds and
spending on goods and services. Financial control, as the successor
to monetary control, would regulate creation of financial assets
in all forms 'Tight finance' and 'cheap finance' are the sequels
of 'tight money' and 'cheap money.' ***A monetary authority which
is tempted to stay within the bounds of its traditional controls because
they are quantitative, general, and impartial, may find itself more and
more out of touch with credit developments in critical growth areas where
lending by nonbank institutions is predominantNonbank institutional
lenders give rise to special problems in financial control because they
are imperfectly competitive and also because they are specialized.***"

In reality, instead of progressing from "monetary control" to "financial
control" as was astutely prescribed, the U.S. system basically drifted
into a dangerous lack of control of money, credit, or finance generally. We
are today in an environment where to even suggest that there should be some
control over money and credit expansion is sacrilege. But there is one momentous
problem: we are stuck in this Bubble of mounting financial claims, with the
leading credit creators being dominating financial institutions specializing
in aggressive asset-based lending. And as much as Wall Street would like to
trumpet the death of inflation, Wall Street is THE INFLATION, albeit in a most
unfamiliar manifestation. At the same time, this financial Bubble could not
be more conspicuous; financial fragility could not be more obvious.

"The restrictions are responsible for the power of the banking system
to create money only in the sense that by preventing the actual creation
of money it keeps the potential, the power, of creating money from being
used up." Abba Lerner

Perhaps it is today a case of an uncontrolled monetary system having about
reached the point of having its capacity to create "money" "used
up." It should be obvious that there are limits to sound monetary expansion.
History is so clear on this issue: If money is abused, there's going to be
a crisis; at some point there will be a "run" from specious financial
claims. Traditionally, such monetary excess would have long ago fueled problematic
consumer price inflation, forcing the Fed to have slammed on the breaks. But
it truly is different this time, with unique financial structures and inflationary
manifestations. Today, the critical issue is the wholesale multiplication of
a variety of financial claims not supported by sufficient underlying economic
wealth creating capacity. It is a critical U.S. issue domestically, as well
as internationally. And make no mistake, the day that depositors question the "moneyness" of
these mounting U.S. claims there is a serious systemic crisis. We have also
often stated that the U.S.'s momentous relative advantage in creating top-rated
securities and "money" has been a key aspect of the dollar Bubble.
Unfortunately, there will be no separating the developing problems in Wall
Street "structured finance" from confidence in the soundness of the
U.S. monetary system. They have become tightly interlinked. This is why I have
always associated the "money" issue with the dollar "issue".
It then becomes a question of the time remaining - how long will the U.S.
financial sector sustain the "power" of creating "money" before
it is "used up"? If monetary abuse makes the clock tick faster,
the hour hand is in a whirl.